Avoiding the ESG backlash: six recommendations for reporters

A belief that investors need to step-up and help to solve some of the most difficult long-term challenges thrust ESG into the mainstream at the start of this decade. Yet only a couple of years later we are seeing a backlash. At the heart of this are differences and misunderstandings that need to be debated and ironed out - fast. In the meantime, there are things that companies can do to avoid the ESG backlash. 

 

The traditional role of investors has been evaluating companies on their commercial performance. Broadening this to judge their environmental and social record brings considerable challenges. Companies know what information investors need to assess their financial performance, but the requirements to assess non-financial performance are still emerging.

 

In addition, a lack of clarity of purpose and transparency around investment decisions within the asset management industry has created problems. Responsible investment traditionally takes an inward view and considers ESG as inputs into the investment process to assess the potential risk-adjusted returns of a stock. This is different to an outward view, where the focus is on an ethical or environmental goal. The former allows some flexibility to invest in a polluting manufacturer if these risks are considered less material than other drivers of returns and discounted in the share price. The second does not. A failure to separate these different philosophies leaves an industry talking at cross purposes.

 

Political factors are also having a bearing and there is a backlash from both sides of the spectrum. Some on the right think asset managers are pushing a political agenda through their clients while some on the left don’t think new ESG measures go far enough. The division is most pronounced in the United States but it affects decisions on this side of the Atlantic too, not least because the biggest asset managers are American. Having supported nearly half of environmental and shareholder proposals in 2021, Blackrock, the world’s largest asset manager, is reducing its backing for them on the basis that they are too prescriptive. Vanguard, another of the biggest index investors, has also rowed back and recently abandoned a global accord on net-zero carbon targets for investments.

 

Understanding the complexity and scope of the challenges that ESG initiatives seek to address can help companies avoid getting caught up in a backlash that casts a shadow over much-needed change and help them present a clearer view of progress. Here are six recommendations for reporters:

 

1.           Set clear objectives.

2.           Address trade-offs to bring clarity to objectives.

3.           Avoid outlandish claims and be honest about the challenges your business faces.

4.           Carry out a materiality assessment.

5.           Ensure long-term targets have short and medium-term milestones.

6.           Embed sustainability disclosures and align them with key sections of the annual report.

 

Set clear objectives.

Companies need to be clear about their priorities and set clear objectives. In this respect, they shouldn’t be guided solely by ESG rating agencies. Companies seek good scores from ESG ratings agencies, which in turn influence investor decision making. But ESG scores don’t reflect how sustainable a company is. Rather they reflect the resilience of an organisation to the risk posed by sustainability-related impacts. In addition, ESG scores are hindered by a lack of transparency and comparability. A study of six ratings agencies by academics from MIT Sloan School of Management found they used 709 different metrics across 64 categories but only ten categories were common to all.

 

Being clear about priorities and setting clear objectives enables investors to make their own judgements rather than relying solely on ratings agencies.

 

Address trade-offs to bring clarity to objectives.

In our experience, companies are reluctant to address the inevitable trade-offs in their reporting. This is the case in many integrated reports, where reporters are invited to comment on trade-offs between capitals, which are used to measure stores of value. Closing a coal mine and managing the site to increase biodiversity will, for example, increase the stock of natural capital but lower the stock of human capital as miners lose their jobs.

 

To the consternation of its chief executive, Tesla’s high ESG scores for driving the transition to electric vehicles are offset by weaker scores for corporate governance. A corporate governance code where companies are encouraged to comply or explain provides a means to address trade-offs like this. In fact, regulators encourage companies to make their case when they don’t comply as it provides a better insight into how the business is run.

 

Addressing these conflicts will bring clarity to objectives, not addressing them will foster delusion and cynicism.

 

Avoid outlandish claims and be honest about the challenges.

Reporters should also avoid outlandish claims and resist the temptation to simply plaster the word sustainability across existing sections. There is a tendency to make Barnum-style statements – that is, statements born of a mistaken belief that generic descriptions and statements truly apply to ourselves, when in fact they’re vague enough to apply to almost anyone. Declaring that one of your company’s objectives is to save the planet is likely to sound hollow. It is better for companies to more closely consider their sphere of influence when setting objectives. Anything else adds unnecessary noise and reduces credibility. Being honest about the challenges you face also adds credibility. Nobody expects companies to solve climate change in isolation, overnight. Anything that suggests a linear journey without bumps in the road undermines your message.

 

Focus on what is material. 

We strongly recommend a focus on materiality to identify social, environmental and economic impacts. This will help companies set objectives and shape their strategy as well as prioritising the areas they need to report on. The International Sustainability Standards Board (ISSB) considers the impact of sustainability through an investor lens requiring information about how environmental, social and economic topics could impact financial performance. This is also the approach adopted by the SEC in the United States.

 

The European Union has gone further: its ESRS standards widen the definition of materiality to require a company to consider how it has impacted, or will impact, stakeholders, environmental and social issues in the wider world. This is known as double materiality. It is therefore leading the way when it comes to considering what economists would call negative externalities.  This is the impact of commercial activities on things like climate, water and biodiversity, which are available to everyone but can be overexploited at a high environmental cost. It has been too easy to ignore these costs. Most ESG ratings agencies, for example, currently measure the risks that climate change pose to a company, rather than the threat the company poses to the climate.

 

Set short, medium and long-term targets and measure progress.

Another piece of the jigsaw is measurement and reporters will be familiar with the efforts of the ISSB and EU to bring much needed standardisation to enable clear comparisons between companies. Measuring carbon emissions, for example, is critical to tackling climate change, either as a basis for regulation to rein in emissions or for giving investors the opportunity to create a shadow carbon price, in which the biggest polluters are penalised by the markets. The ISSB aims to make non-financial disclosures as consistent as financial ones in a company’s annual report.

 

Better measurement enables better targets but the longer-term nature of addressing climate change is leading companies to put down markers for 2030 or 2040 without explaining how they are going to achieve them. Climate Action 100+ is a pressure group that aims to hold 166 of the world’s biggest emitters to the Paris targets. It found that while 69% of them had committed themselves to reach net zero by 2050, only 17% had set medium term targets or quantified decarbonisation strategies. Showing how you ladder up to long term targets is vital to communicating a credible story on sustainability. Tying these to directors’ remuneration will underline the company’s commitment.

 

Embed ESG disclosures and align them with key sections of the annual report.

The drive for parity between financial and non-financial information has created challenges and the desire not to fall foul of the regulators risks overwhelming annual reports with very detailed information on ESG. Key sections, such as corporate strategy, that run over two to four pages suddenly start looking very sparse next to reams of detailed Task Force on Climate-related Financial Disclosures (TCFD).

 

We expect this to eventually find an equilibrium as more companies carry out materiality assessments, become more comfortable with new regulation and the ESG rating agencies align their approach and achieve more consistency. By determining the topics that are most impactful inwards and outwards, materiality will inform the boundaries of scope for reporting.

 

In the meantime, ESG disclosures should be aligned with existing disclosures such as the business model and principal risks, which is also a good way of showing readers where companies are directing their efforts.

 

Reporting can play a vital role in the fight against climate change and some of the most difficult long-term challenges we face today. Taking these steps will instil credibility and help avoid the ESG backlash.

 

 

Want to chat to us about ESG, reporting or your sustainability communications? Get in touch.